Emerging market debt is maturing into a less volatile and more diverse market. Here's why we think it should be considered for part of a broadly diversified portfolio:

The source of emerging market growth is shifting from external to domestic demand. In terms of consumer demand, emerging markets are becoming more self-sustaining. A rising middle class is spurring consumer demand for local goods and services, and the establishment of private pension systems in several emerging countries is building the presence of a stable, local institutional investor base. That's why emerging market aggregate consumption now exceeds consumption in the United States.

The range of investment possibilities has broadened. As emerging market economies have matured, the number of debt investment opportunities has increased. The core of these opportunities is hard currency government bonds denominated in U.S. dollars.

Emerging market bonds can diversify a U.S.-centric portfolio. Investing in emerging market bonds can diversify a portfolio of U.S. bonds. Indeed, the correlation between the Barclays U.S. Treasury Index and the J.P. Morgan GBI-EM Global Diversified Index was 0.08 since inception (with 1.00 representing a perfect correlation and 0.00 representing no correlation).1

Falling debt levels due to better macroeconomic policies and structural reforms. The debt ratings of these economies have been persistently improving. As a group, they issue less debt to investors than more developed nations. Whereas the debt-to-GDP (gross domestic product) ratio in developed nations is between 80% and 100%, this ratio is far smaller in emerging markets at between 35% and 40%.

The emerging market corporate bond asset class continues to grow. The asset class continues to mature and is now comparable with the U.S. high yield market in size. Individual companies, in many cases, are conservatively leveraged and managed with large cash reserved and little debt on their balance sheets, yet they have a greater tailwind for growth.

Growing middle class should drive global demand for consumer demand. The number of people in the BRIC countries (Brazil, Russia, India, and China) with annual incomes of at least U.S. $6,000 will grow by 70% over the decade.2 The average annual income of Chinese workers grew by 35% a year from 2003 to 2010, while in Brazil the number of middle- and upper-class consumers has grown by about 50% since 2005.

Credit ratings of many emerging market countries have been on an upward trend. Since 2001, the average rating on the asset class has moved from high yield firmly into investment-grade territory. Further, the local debt market is now the highest-rated emerging market debt asset class, with more than 80% of the market carrying an investment-grade rating.3

Liquidity in local currency bonds has improved dramatically. Trading volumes in secondary market local currency bonds (as a percentage of total emerging markets debt trading volume) have risen from 42% in 1992 to 70% in 2012.4

Investing in the securities of non-U.S. issuers involves special risks not typically associated with investing in U.S. securities. Foreign securities tend to be more volatile and less liquid than investments in U.S. securities and may lose value because of adverse political, social, or economic developments overseas.

The risks of foreign investing are heightened for securities of issuers in emerging market countries. Emerging market countries tend to have economic structures that are less diverse and mature, and political systems that are less stable, than those of developed countries. In addition to all of the risks of investing in foreign developed markets, emerging markets are more susceptible to governmental interference, local taxes being imposed on foreign investments, restrictions on gaining access to sales proceeds, and less liquid and efficient trading markets. Companies and governments issuing lower-rated bonds are not as strong financially as those with higher credit ratings, and their bonds are often viewed as speculative investments. To the extent the funds use forward foreign exchange contracts, swaps, options, or futures, they are exposed to additional volatility in comparison with investing directly in bonds and other debt securities.

Diversification cannot assure a profit or protect against loss in a declining market.

1The J.P. Morgan GBI-EM Global Diversified Index began operations in January 2003; data shown are from January 2003 to December 2012.2OECD.3As represented by the J.P. Morgan Government Bond Index—Emerging Markets Global Diversified, as of September 30, 2012.4Emerging Market Trade Association, as of September 30, 2012.

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